Are there California trusts which the IRS may not recognize?

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Setting up trusts creates a complex web of financial, fiduciary, personal and tax consequences. A trust is a creature of the Common Law and often defined as a fiduciary relationship in which a trustee holds title to property for the benefit of beneficiaries according to the grantor’s manifested intent. This concept is extremely flexible, and, indeed in California and elsewhere “a trust may be created for any purpose that is not illegal or against public policy”. CA Probate Code 15203.

However, the IRS, ever vigilant to spot attempts of tax avoidance, is not so generous. What is a trust under local law may on occasion not be recognized as a trust under the Internal Revenue Code (IRC) and conversely, arrangements, not designated as trusts by local law may so by the IRS. For example, an obligation that has the substantive characteristics of a debt will be treated as a debt for federal tax purposes, even if it labeled as a trust. The same applies to an agency relationship. An agent who acts as ‘trustee’ but is only a nominee of the principal will not be treated as trustee by the IRS. Complications can arise under guardian and conservatorship but typically the minor child is recognized as the owner of the property, therefore, no trust. Business trusts validly created under local law are likely to be classified as partnerships or corporations.

The underlying principle of the preceding examples is that a purported trust will be classified according to its real character under the ‘resemblance test’ (Morrissey v. Commissioner, 296 U.S. 344 (1935)).

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